The taxation of forex contracts is complex, but at least it gives you options. No pun intended. Among the key decisions any forex trader must make, though, is deciding on the tax regimen that will govern his or her trades. How do you want your profits or losses to be treated under the tax code? Uncle Sam gives you two options: Do you want to treat them as an ordinary gain or loss, as described by Section 998 of the Internal Revenue Code? Or do you want to take advantage of lower long-term capital gains rates?

What’s that, you say? All your forex trades were concluded well within a 1-year period and you have no long-term capital gains? Au contraire, mon frer! An often-overlooked quirk of the tax code, under IRC Section 1256, actually allows you to treat 60 percent of your capital gains from currency trading at the lower long-term capital gains rate – even though all your trades were short-term!

Section 1256 generally applies to foreign currency futures traded on U.S. exchanges, while other forex contracts fall by default under Section 998 – unless you opt out. More on that in a bit.

Under Section 1256, the IRS deems all long positions “sold” at the end of the year – whether or not they actually are – and marks profits or losses accordingly for tax purposes. The IRS uses the fair market value of the contracts as of the year-end to make the calculation.

It’s up to you, however, to make the election. If you are trading in retail spot contracts or anything other than foreign currency futures contracts. the IRS will channel your trading into the Section 998 system. This is good if your trades were a net money loser: Treating your losses as ordinary losses, rather than capital losses, allows you to deduct your losses against any type of income. Caps on capital losses are removed, as long as you have other income to deduct them against.

Foreign currency gain or loss, defined.

For the purposes of Section 998, The term “foreign currency gain” means any gain from a section 988 transaction to the extent such gain does not exceed gain realized by reason of changes in exchange rates on or after the booking date and before the payment date.

The term “foreign currency loss” means any loss from a section 988 transaction to the extent such loss does not exceed the loss realized by reason of changes in exchange rates on or after the booking date and before the payment date.

That’s straight out of the IRC, Ch. 26, Section 988, which you can read here.

Opting Out

If you want to opt out of Section 998, and take your chances with Section 1256 instead, you must commence a written record that you intend to opt out. You don’t have to file anything in advance with the IRS, strangely enough. You just have to create this written documentation before you start entering trades.

Now, there’s an opportunity to cut a corner here: Some traders might prepare an opt-out document at the beginning of the year, and then ‘disappear it’ if they have net losses, taking advantage of the higher loss deductions under Section 988. Thus far, the IRS has been strangely tolerant of this practice. We don’t expect that to continue indefinitely. As forex traders become a bigger and bigger piece of the investment world, and as forex traders increasingly become a ‘deep pocket for the IRS to pick, that particular opt-out provision is likely to come under increased scrutiny in the future.

When Should You Opt Out?

When you believe your trading will be profitable, of course! By electing to have the IRS assess taxes based on Section 1256, you will benefit from a 60/40 allocation of long-term and short-term capital gains. That is, 60 percent of your gains will be taxed as long-term capital gains, while 40 percent of your trade will be taxed as short-term capital gains.

This is strongly preferable to treating profitable trading under Section 998, since if you are an active trader, all or nearly all your trades are likely to fall under the higher short-term capital gains tax.

To Take the 1256 Treatment

To take the 1256 treatment, you would file an IRS Form 6781 – Gains and Losses from Section 1256 Contracts and Straddles, in conjunction with the opt-out election document described above.

Your Form 1099

If you trade futures contracts, your forex broker should have sent you a Form 1099 already, detailing your trading gains and losses for tax year 2013. Look on Line 9 for your total gain or loss.

If you’re out there surfing the interbank markets directly, however, you won’t get a 1099.

Note: WinnersEdgeTrading.com does not provide individualized tax advice. This article is for informational purposes only and should not be construed to represent specific tax advice. You should always make your decisions based on the advice of a qualified tax professional, experienced in forex trading matters, licensed in your jurisdiction.

Disclaimer: Trading forex on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before deciding to invest in foreign exchange you should carefully consider your investment objectives, level of experience, and risk appetite. The possibility exists that you could sustain a loss of some or all of your initial investment and therefore you should not invest money that you cannot afford to lose. You should be aware of all the risks associated with foreign exchange trading, and seek advice from an independent financial advisor if you have any doubts.

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